Stock to Consider: Delta Air Lines

Atlanta-based Delta Air Lines, Inc. (NYSE: DAL – $49.71) is a major international airline with ten airport hubs including New York (JFK and LaGuardia), Los Angeles, Atlanta, Detroit, Minneapolis, Seattle and Salt Lake City. Internationally, Delta provides service to every major international market as part of the Sky Team Alliance with Air France-KLM, Alitalia, Korean Air and Virgin Atlantic, among others. Delta gets about two-thirds of its revenue domestically, where trends have been more favorable than on overseas routes. Revenues by geographic region: United States – 70%; Atlantic – 15%; Pacific – 8%; and Latin America – 7%. Regional service is operated under the brand name Delta Connection. In October 2008 Delta acquired Northwest Airlines making it the largest carrier in the world in terms of scheduled passengers. The company also owns and operates an oil refinery in Pennsylvania.

Delta is widely viewed as the best-run major U.S. airline with disciplined capital spending, ample profit margins and an aggressive plan for returning capital to shareholders. The company also has been spending to refresh its fleet and upgrade terminals at key airports like Los Angeles International and New York’s LaGuardia. The company has a relatively old fleet of 832 aircraft, averaging about 16.6 years, against 9.8 years at American and 14.4 at United. It has replaced a quarter of its fleet in the past five years, and may replace another 25% by 2020.

Delta’s second-quarter earnings of $1.68 a share matched expectations, as did current-quarter guidance of 2.5% to 4.5% growth in passenger unit revenue and an 18% to 20% operating margin. Delta is calling 2017 a “transition year” as it digests fuel-price increases, aircraft purchases and a new pilot contract. Earnings this year are expected to be little changed from 2016 at about $5.43 per share. Delta’s goal is to limit nonfuel cost increases, mostly labor, to 2% annually in the next few years. Management has been strategically ahead of the industry and a good allocator of capital. Delta has also moved to improve its balance sheet and bolster an underfunded pension plan. It has an investment-grade bond rating on net debt of $8.4 billion. It aims to reduce that to $4 billion by 2020. Sooner or later, Delta’s operational and financial performance will get recognized by investors, and the company’s shares and valuation should move higher. Some analysts believe the shares could trade at 13 to 15 times earnings in a year or two as compared to 11 at current levels

Last year Delta repurchased $2.6 billion of its stock, or 7% of its shares. Buybacks could rise in the next few years if it hits its annual free-cash-flow targets of $4.5 billion to $5.5 billion. The airline plans to return 70% of its free cash flow to shareholders and to lift the $0.81 per share dividend 50%. Thus, long-term investors willing to assume some risk in this volatile and competitive industry may want to take a closer look here. Margins should start to pick up steam next quarter, setting DAL up for solid earnings growth over the long haul. I am initiating Delta with an 8% allocation in the portfolio.